I don't know for a fact that anyone's singing "Happy Days Are Here Again" at Illinois kefir maker Lifeway Foods (NASDAQ:LWAY) today -- but if they aren't, they should be. After a Q1 2007 earnings report that beat analyst estimates on Monday, and a 10-KSB filing with the SEC that confirmed and expanded on the good news Tuesday, investors and management alike should be in high spirits today.

Two months ago, I highlighted the risk that rising milk prices posed to Lifeway's business, and that of fellow dairy producers such as General Mills (NYSE:GIS), Dean Foods (NYSE:DF), Kraft (NYSE:KFT), and Danone (NYSE:DA). In Monday's report, Lifeway CFO Edward Smolyansky indeed confirmed that Lifeway's "largest raw material" had risen 10% in price versus last year's fiscal first quarter, understandably squeezing gross margin. While the firm boasted 50% sales growth (28% "organic" growth, plus additional revenue streams from last year's Helios acquisition), its cost of goods sold raced ahead 65%. As a result, gross margin contracted 530 basis points to 39.6%.

But don't fret. Thanks in part to bringing some of Helios' low-margin kefir production in-house at Lifeway's more mechanized Illinois facility, partly to simply benefit from economies of scale, Lifeway managed to make up some of the gross margin erosion in operating costs. After holding its sales and marketing expenses to just a 32% rise, and its other operating costs to a 41% increase, operating margin lost just 340 basis points year over year. Lifeway ended up with an even 20% operating margin.

A couple of sour notes
Profit-wise, all the above worked out to about a 28% rise in Lifeway's net earnings for the quarter -- considerably shy of sales growth. Worse still, that was just the picture under GAAP. From the perspective of actual cash profits after capital expenditures -- free cash flow -- the firm actually lost money.

But a sweet aftertaste
That said, when stacked up against last year's negative free cash flow of more than $50,000, the mere $4,200 net cash outflow in the Q1 2007 results shows considerable improvement. Moreover, the firm has spent less on capital expenditures so far this year, and it grew its operating cash flow much closer to the rate of revenue growth -- 40%.

Put it all together, and while I hesitate to call Lifeway's corporate skies "clear again" just yet, there's considerably less grey up there than we saw last quarter.

For more on this little kefir maker that (possibly) could, read:

Fool contributor Rich Smith does not own shares of any company named above. Kraft is an Income Investor pick. The Fool's disclosure policy could go for a smoothie.